The Fractional Reserve Banking Sideshow

I have seen a recent flurry of articles, including one by Austrian School Economist, Frank Shostak, of the Mises Institute, discussing the evils of Fractonal Reserve Banking (FRB) regarding the Boom-Bust Cycle.

While I also am a Free Market guy, subscribing to the Austrian School, I think the critics of FRB are allowing themselves to fight the wrong fight – to be diverted by a red herring.

Let us consider three countries. Each one has a Money Supply of $1 Trillion, which has remained constant for several years. Country 1 has as its money a Gold Standard. Country 2 uses a 100% paper currency. And Country 3 has a basic, unchanging money supply made up of 1/10th base money (either Gold or paper money – take your pick), plus 90% bank credit of the FRB type, totaling $1 Trillion.

All three countries have maintained their money supplies without increase or decrease for several years. All three Economies have produced roughly the same GDPs for several years, which have produced roughly unchanging prices.

The rulers of Country 1, the Gold Bug people, have discovered a source for additional Gold, and so they have chosen to increase their “money supply” by 10%. Predictably, the general price level goes up over time by 10%. (I expect that a few Austrians would have a knee-jerk reaction and say that prices would not go up, but I think they would be mistaken.)

The rulers of Country 2, the Fiat people, rev up the printing presses, and they too raise their money supply by 10%. Just as with Country 1, prices in Country 2 rise over time by 10%.

So far, both Countries 1 and 2 have increased their money supplies by $100 Billion each, and prices have gone up by 10% over time.

Now, we come to Country 3. The rulers have a basic money supply of $100 Billion plus their banks have created an additional money supply of $900 Billion, for a total money supply (from the point of view of the whole Economy) of $1 Trillion.

Country 3’s rulers desiring to reap the “benefits” of money inflation, raise their money supply by 10%. The base supply goes up only $10 Billion, and the FRB system causes an additional rise of $90 Billion. They also will have caused prices to go up over time by 10%.

Each Economy appears the same, except that Country 3’s rulers got there by printing only $10 Billion extra, compared to the $100 Billion additions in Countries 1 and 2.

In each of these countries, the only change was that the rulers chose to raise the money supply by 10%. Fractional Reserve Banking has NOT caused the rise in money supply – it just went along for the ride. (Keep in mind that the banks in Country 3 had to pay somebody for the new bank reserves on which it based its newly created loans.)

There was no difference between the three countries’ results: money supply and prices up by 10%. If each set of rulers chose not to increase their money supplies further, then the money supplies and prices would remain in the new equilibrium.

If all three chose to inflate again – or continuously – the results would be the same in all three: over time, the price levels would go up by the percentage that the money supplies went up (all else being equal, which it never is). The only difference between the three choices is that the Gold Standard (my preference) offers a greater protection for the Economy from the rascals heading the country in their usual preference of debasing the Money of the Country.

During the time that the money supply expansion is working its way through the Economy, and while prices are rising, this would appear as a Boom period. Once the new equilibrium was reached, then the lack of continued money supply expansion would appear as a Bust period – the Boom-Bust Cycle still would devil the Economy.

Continued expansion of the money supply, in any of the three countries, would appear essentially the same.

It is NOT the FRB that does evil in the Economy. It is the debasing of the basic money supply. This is the enemy of the Economy which must be the focus of attention. The sideshow of Fractional Reserve Banking must not be allowed to deflect attention away from Money Supply Debasement. It is the rulers’ ability to raise the money supply which must be stopped.